“From two evils…”: how to build healthy corporate governance

I faced up the difference in understanding of corporate governance between the Western and our world the first time, when learned the Harvard case study of Yukos during my Executive MBA program “Mergers and Acquisitions” in the University of Vienna. Yukos case described events, that had happened until 2004.

The main focus was on Yukos attempts to enter an IPO on the US stock exchange in the early 2000s. It described the bankruptcy of Menatep Bank in 1998, a violation of the rights of minority shareholders, including an American pension fund, lawsuit of the pension fund to Yukos assets plugged in the bank, as well as subsequent attempts of Yukos to become more attractive among international investors. The case described an attempt to introduce at the company the best international corporate governance practice. Independent non-executive directors, recognized international experts, had been included in the supervisory board of Yukos.

According to the authors of the case, the goal of this step was to create confidence in the company from American investors. Yukos did not manage to place his shares in international markets. We remember, how the events unfolded, and what had happened with the company and its owners. I don’t think that the violation of the minority rights of influential shareholders was the direct consequence of Yukos’ problems. However, mistakes during the bankruptcy prevented nevertheless indirectly the team from attracting large foreign investors on time and did not let to create a balance of interests among investors.

Unlike the Western world, we do not take corporate governance too seriously. Shareholder meetings, supervisory board, audit, public reporting are an extra headache for the management of our joint-stock companies. For most of them, this is rather the rules of the game, that they have to play in order to comply with the law or to receive the right to issue shares in exchange for investor money. Ballet pas on the stage of corporate finance. In general, this is understandable. Our capitalism is a little bit more than 25 years old. Many owners of business have been still involved themselves in the operational management of their companies. Why to create a supervisory board, to introduce regulations and reporting, and to control themselves? For most business owners, corporate governance is an unnecessary but inevitable evil, the impact of which on the company should be limited.

However, life is a finite and a change of power is inevitable. Sooner or later, the owner needs to move away from operational management, and transfer the government into the hands of young generation of inheritors . The problem is that not all heirs are ready and want to continue the glorious work of the fathers. Many are not ready to invest their time and efforts, to work from morning to night, and to give up a calm, prosperous life.

The classic “fathers and children” conflict leads to the fact that operational management has to be transferred to the other hands. Moreover, it is sometimes useful to borrow cheap money in the stock market for further business development. This is exactly time for owners to think about creating a balance of power and a system of control over the activities of hired top managers.

Many enterprises in our market are today at that stage, when the basic conflict between owners and hired top managers show up. Adam Smith formulated this conflict in his book “The Wealth of Nations” in 1776. He said, that as for directors of companies, that are hired managers, when it comes to the money of other people, and not their own, we should not expect, that they will act with the same vigilance as the owners in a private company, who monitor their own money.

According to this quote, the history of corporate governance in Europe dates back to the Middle Ages, when bourgeois entrepreneurs fought against the state and the church, who had been trying to restrict the development of trade and usurers. Through trials and errors, entrepreneurs and bankers developed corporate game rules, which later formed the basis of many modern corporate laws of the Western world.

It will be wise for us to understand this global rules of corporate governance in order to speed up and safe time, that we spent on great social-economic experiments in our countries in last century. Let us turn to Western word experience, critically rethink it and apply the best principles suitable for our mentality and reality.

Corporate Governance Models

There are two different models of corporate governance in the world:
— A single-level or Anglo-Saxon model, which is typical for British and American companies;
— A two-level model, which is typical for European companies and legally adopted in our country.

Each model has its own pros and cons. If we draw an analogy with the state system, then the dispute is going on between the “presidential” and “parliamentary” governance models. Due to a lack of understanding of the essence of these differences, errors arise in the translation and interpretation of terms.

The main difference between two models is, that in a single-level model, the the positions of the head of supervisory board and the chief executive officer (CEO) are combined in one position named head of board of directors. Other executive directors, who are named in the two-level model as members of the management board, are named in a one-level model as members of the board of directors, which also acts as the supervisory board.

To say it simplify, in a single-level model, the board consists of hired managers and owners of business or their representatives and is acting as one working body (Board of Directors) combining both of bodies (management board and supervisory board) in “a single bottle”.

In this model, the board delegates part of the functions to various committees: the audit committee, the appointment and remuneration committee. The standard practice in American companies is to invite independent directors or non-executives members of Board of Directors, who are recognized and independent experts in their industry.

In the two-level model, which is typical for continental Europe and the CIS countries, there is a clear separation of two positions — the head of the supervisory board and the head of the management board, who is also called the chief executive officer. In the two-level model, the supervisory board also often includes independent members, who are required to protect the interests of owners and investors.

The management board in this case includes only executive directors such as a chief commercial officer, chief finance officer, chief risk manager, chief operational and IT officer, and as the new trend, chief data officer.

Since the two-level model has a clear separation between two boards, one of which consists of hired managers and another out of representatives of owners or independent members, the functions of the supervisory board are not delegated usually to committees, as in the single-level model.

Which model works better?

Corresponding studies were conducted by World Bank. It was turned out that among the companies with the Anglo-Saxon model are there more market leaders, but there are also more bankruptcies (Enron, Lemon …). European companies have more stability, but less efficiency.

It seems that the “parliamentary” model gives more balance, stability, but stagnation, while the “presidential” model of leadership leads to risks of failure, but increasing the efficiency and success of the business. If you are lucky with the president, then everything is “in chocolate”. But if it is not…, well, then we have collective responsibility or rather to say, we are reaping the fruits of collective irresponsibility.

What does this mean for us?

Now we face a paradox. At the legislative level or de jure, we have secured a two-level “parliamentary” model, but mentally we are closer to the “presidential” model of a strong leader.

Moreover, our capitalism is young, and owners have just begun to move away from operational management. Due to the youth of the system in our country, a single-level model has been formed de facto. Therefore, the two-level model of corporate governance is puzzling many owners, who simply have no time and reason to play by these rules.

However, the life, of course, will make us move. True, as always, the truth  is somewhere in between. In fact, in terms of global best practice, it is important for a company to take the best out of both of models. And how to do it, I will describe in the next articles.

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